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Discretionary monetary and fiscal policy with endogenous sovereign risk

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  • Roettger, Joost

Abstract

How does the presence of sovereign risk affect the conduct of public policy? To answer this question, this paper studies optimal monetary and fiscal policy without commitment for a model economy with nominal public debt and strategic sovereign default. Compared to an economy without the possibility of default, economies with sovereign risk experience more volatile interest rates, which impedes the government’s ability to smooth tax rates across states. Risk of default also limits public debt accumulation, reducing the government’s incentive to use surprise inflation on average. When calibrated to the United States, the model predicts that a counterfactual increase in the average annual default probability from 0 to 1% lowers average inflation by 33%, raises the standard deviation of inflation by 18% and increases the standard deviation of the labor income tax by 73%. The transmission of exogenous shocks to real aggregate quantities is however almost unaffected by the possibility of default. For example, the presence of sovereign risk would increase the standard deviation of log real GDP by less than 1% in the experiment above. Similarly, the welfare consequences of sovereign risk are found to be of negligible size as well.

Suggested Citation

  • Roettger, Joost, 2019. "Discretionary monetary and fiscal policy with endogenous sovereign risk," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 44-66.
  • Handle: RePEc:eee:dyncon:v:105:y:2019:i:c:p:44-66
    DOI: 10.1016/j.jedc.2019.05.010
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    More about this item

    Keywords

    Optimal monetary and fiscal policy; Discretion; Public debt; Sovereign default;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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